Consider a project to produce solar water heaters. It requires a $10 million inv

Question

Consider a project to produce solar water heaters. It requires a $10 million investment and offers a level after-tax cash flow of $1.75 million per year for 10 years. The opportunity cost of capital is 12%, which reflects the project’s business risk. Assume that the project is financed with $5 million of debt and $5 million of equity. The interest rate is 8% and the marginal tax rate is 35%. The debt will be paid off in equal annual installments over the project’s 10-year life.

Required: (a) Calculate the Adjusted Present Value (APV). (10 marks)

(b) How does APV change if the firm incurs issue costs of $400,000 to raise the $5 million of required equity? (4 marks)

(c) Assuming that the solar water heaters project has a NPV, when all equity financing, of $500,000. To finance the project, $10 million in debt is issued with associated flotation costs of $200,000. For tax purposes, the flotation costs has to be amortized over the project's 10 year life. The debt is issued at 10% interest with the repayment of principal due in a lump sum at the end of the tenth year. As stated above, the firm's tax rate is 35%. Calculate the project's APV. (7 marks)

(d) Under what circumstances would it be better to use the Adjusted Present Value approach? (4 marks)

Explanation / Answer

Part - A

Adjusted Present Value

Net Present Value of Equity  

Discounted Cash Inflow = 1.75 Million *5.650(12% Present Value Factor for 10 years

=9.8875 Million

Net Present Value = 9.8875 Million - 10 Million

=-0.1125 Million

Present Value of Debt Financing  

Tax Saving Interest Present Value Factor = 0.14 Million (5 million *8%*35%)*6.710 (8% Present Value Factor for 10 Years0

=0.14*6.710

=0.9394 Million

Adjusted Present Value =Net Present value +Present Value of Tax Saving interest

=-0.1125+0.9394

=0.8269 Million

Adjusted Present Value = $ 0.8269 Million

Part - B

Incurs Issue costs of $ 400000 Raise 5 million Equity

Adjusted Present Value = 0.8269 -0.4000

=$ 0.4269

Part - C

Net Present Value = 200000

Tax Saving interest and Floatation cost

Interest Tax Saving = 10 Million *10%*35%

=0.35 Million *6.1446 (10% Present Value factor for 10 years)

=2.15060

Interest Tax Saving and Floatation cost = 2.15060 Million+0.20 Million

=2.35061 Million

Adjeusted Present Value = 2.35061+0.50 million

= $ 2.85061 Million

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